BLOG POST

Tech & Sourcing @ Morgan Lewis

TECHNOLOGY, OUTSOURCING, AND COMMERCIAL TRANSACTIONS
NEWS FOR LAWYERS AND SOURCING PROFESSIONALS

In this contract corner, we consider the concepts of “good faith” in commercial contracts under English law.

The General Position Under English Law

The notion of good faith is a complex and evolving concept under English law, and it has important implications for those drafting commercial contracts. In contrast to many other civil (e.g., France and Germany) and common (e.g., United States and Australia) law jurisdictions, there is no general doctrine of good faith either in negotiating or in performing a contract. Instead, parties are free to pursue their own self-interests, so long as they do not act in breach of contract. However, the notion of good faith can still impact commercial contracts in three main ways:

  1. If parties expressly agree to act in good faith, careful drafting is required to ensure that the courts will give effect to the parties’ intentions
  2. In certain limited circumstances, courts may imply a general duty of good faith
  3. A party must exercise a contractual discretion in good faith when that discretion confers on that party the power to make a decision that affects the interests of both parties

1. Express Obligations to Act in Good Faith

Although contractual terms requiring the parties to negotiate in good faith are generally unenforceable, parties may negotiate and agree express terms requiring one or more parties to act in good faith in relation to performing the agreement or specific obligations. However, the validity of such express terms is not always certain.

English law does provide parties with a degree of flexibility in the language that can be used to create a duty of good faith (e.g., the obligation has arisen from an agreement to “act with the utmost good faith” and to “resolve disputes by friendly discussion”).

However, that flexibility is limited. An agreement to “have regard” to certain principles, including for all dealings to be “open, honest, clear and reliable,” was held not to create a duty of good faith. Further, the express duty to act in good faith is often construed narrowly by English courts so that it applies only to certain provisions rather than the agreement as a whole.

What does a duty of good faith mean in the context of an express obligation to act in good faith? Generally speaking, the duty of good faith is a negative duty to refrain from acts of bad faith rather that imposing a positive duty to act in good faith, though English courts have in one instance imposed a positive duty to disclose all material facts. Importantly, express obligations to act in good faith will not undermine contractual rights (e.g., termination rights) or force a party to forego its commercial interests.

2. The Implied Duty of Good Faith in Relational Contracts

The most significant development in English law on this topic has been on implied duties of good faith in “relational” contracts. If a contract is “relational,” then the parties are subject to duties of good faith as a matter of law, and thereby the parties are prohibited from conduct which in the relevant context would be regarded as commercially unacceptable by reasonable and honest people.

Whether or not a contract is a relational contract is fact-specific. The criteria that will be considered to determine whether a contract will be relational include, but are not limited to, whether (i) the contract is a long-term contract; (ii) there is a high degree of collaboration between the parties; and (iii) there is significant investment by one or both parties in the venture. Examples of relational contracts might include some joint venture agreements, franchise agreements, and long-term distributorship agreements.

Fact-specific terms may also be implied into relational contracts if they are consequential to the duty of good faith. These could include such obligations as keeping proper records of transactions, and a duty to properly and fairly investigate accounting shortfalls.

Similarly, but not identically, to the express duty of good faith, “relational” good faith is best interpreted as preventing a party from acting dishonestly or with a lack of fidelity.

3. Exercising Contractual Discretions in Good Faith – the “Braganza” Duty of Rationality

Where one party has the power to make a decision that affects the rights of both parties, that party has a clear conflict of interest. In response, English courts have sought to ensure that such powers are not abused by implying a term that the power is not exercised in an arbitrary, capricious, or irrational manner. A distinction is drawn between decisions that involve an assessment of, or choice between, a range of options and the exercise of absolute contractual rights. A duty of good faith may be implied to the former but not the latter. The key factor being that the duty may be implied where one party has a “fact-finding” role in making the decision that affects both parties.

Parties should therefore be aware that the exercise of a contractual discretion may be subject to challenge. Precise drafting to exclude a duty of good faith, or to define its scope, is crucial and documenting evidence in support of a proper decisionmaking process is well advised.

4. Conclusion

English law’s relationship with the concept of good faith continues to develop. Although the long-established principle that there is no general duty of good faith in English contract law holds firm, the obligation continues to find its way into commercial contracts by virtue of express terms but also, and more significantly, by implication in circumstances of relational contracts and contractual discretion. A number of recent cases serve as an important reminder to adopt rigorous drafting procedures so that any exclusion or definition of good faith is precise, and therefore able to minimise any uncertainty and faithfully reflect the parties’ intentions.